Thomas Wipf, Vice Chairman of Institutional Securities at Morgan Stanley, will chair the 21-member Subcommittee, which is comprised of a wide range of industry participants that have a high-level of expertise and experience with interest rate benchmarks, as well as LIBOR transition efforts, including asset managers, exchanges, clearinghouses, end-users, intermediaries, market makers, service providers, swap execution facilities, and trade associations.

“I am grateful to all of the extremely qualified individuals who volunteered to join the Subcommittee. I am confident this group of 21 members will thoughtfully fulfill the stated goals of the Subcommittee by providing the MRAC, and ultimately the Commission, with well-reasoned recommendations that will serve to both guide a smooth transition to a risk-free rate, and ultimately protect millions of American consumers from higher costs,” said Commissioner Behnam.

The Subcommittee was established to provide reports and recommendations to the MRAC regarding ongoing efforts to transition U.S. dollar derivatives and related contracts from LIBOR to a risk-free rate (RFR), the Secured Overnight Financing Rate (SOFR), and the impact of such transition on the derivatives markets. Topics and issues this Subcommittee may consider include, but are not limited to, the following:

The treatment, under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, of existing derivatives contracts that are amended to include new fallback provisions or otherwise reference RFRs such as SOFR and new derivatives contracts that reference RFRs; and

Impact on liquidity in derivatives and related markets during the transition.

See full list of MRAC Interest Rate Benchmark Reform Subcommittee members under Related Links.

This provides an opportunity to flashback in time, to June 27, 2017; on that day, the House Agriculture Committee held a hearing entitled:”Clearing the Next Crisis”.

That hearing, taken along with the most recent MRAC hearing, provides an opportunity for extensively deep dive into the world of CCPs, their impact on the market, and managing their default risk.

It’s first noteworthy that Robert Steigerwald of the Federal Reserve Bank in Chicago, testified at both hearings.

“Since I believe that clearinghouses are uniquely dependent on the immediate availability of liquidity in circumstances where private sector liquidity arrangements may be inadequate, I believe that it is crucial for central banks to be prepared to provide liquidity in such circumstances.” Steigerwald said in the 2017 hearing.

What is a CCP?

“People bring contracts to the clearinghouse and the clearinghouse steps between the buyer and the seller,” explained attorney Jerrold Salzman, speaking on behalf of the CME Group before in the June 2017. “It collects from those who lose and pays to those who win. It manages a matchbook is what we call it.”

Another way to look at it, is that CCPs settle all trades, guaranteeing everyone gets paid.

Robert Steigerwald

CCP Default Risk

The hearing in 2017, measured the risk that a CCP could fail and the larger risk that created.

“Failure of a major clearinghouse would be an unprecedent event; such an event would mean there would be a cataclysmic breakdown of the interlocking risk management schemes despite their highly regulated system.” Collin Peterson, a Democrat from the State of Minnesota, said at the June 2017, hearing.

But such an event may have since already occurred.

Marine Rosenberg is the Managing Director and Global Head of Clearinghouse Risk & Strategy, JP Morgan Chase & Co and she testified at the MRAC hearing.

She noted a recent default at a clearinghouse for a European NASDAQ exchange.

“Einar Aas, a derivatives trader who made large bets on the power market, left a 114 million euro ($133 million) hole in the clearing house buffers when his funds ran out, drawing scrutiny from regulators seeking to clarify whether rules were broken.

“Energy firms and other players on the 166-member market had been given until the end of Monday to cover the loss or face default themselves.

“’The Member Default Fund now has been recapitalized by 100 percent, or 107 million euros ($125 million),’ Nasdaq (NDAQ.O) said in a statement.”

The Member Default Fund, is a sort of clearinghouse insurance fund which those who use clearing services are required to contribute into.

Rosenberg said part of the problem is that the wrong party is paying into this fund.

“At same time, clearing members bear the consequences- the capital consequences- of losses through the collective default fund contribution they provide to the CCP for loss mutualization. This model creates an imbalance separating the rewards of ownership from its risks.” Rosenberg said.

CCPs and the Exchanges

Lee Betsil, the Chief Risk Officer for the CME Clearinghouse, was another speaker at the MRAC event.

He noted that even as the CFTC and the Congress provide CCP oversight, the CME clearing division also provides oversight of CCPs which clear on their exchanges.

“CME’s Clearing maintains a dedicated in-house dedicated risk committee, which is comprised of market stakeholders: including clearing member, clients, and independent members. In addition to this committee, the CME maintains a clearinghouse oversight committee which is comprised of board members of CME Group.” He said.

Crighton noted that clearing swaps, which has been in place since the 2008 crisis, has increased clearing activity significantly.

“The increase in volume cleared by CCPs, particularly stemming from the G20 mandate can lead to enhanced financial stability, but also requires that CCPs engage in strong risk management.”

The G20 meeting was in Pittsburgh in 2010 and it laid out the framework where SWAPs would move from over the counter to exchange traded.

SWAPs trading is important because it was swaps, or credit default swaps particularly, which contributed heavily to the 2008 financial crisis.

CDS were supposed to be used by banks to hedge, or offload, credit risk when they’d get too heavy in an asset class like high risk car loans.

It turned into nothing but a casino with few rules in a global market underwriting hundreds of trillions of loans.

To say that the system was out of control is quite an understatement.

The 2010 G20 meeting laid out a new global swaps trading framework- which included CCPs– in response to this excess.

Are Certain CCPs Too Big to Fail

In his opening remarks at the June 2017 hearing, Peterson called the risk of default remote but called such a hypothetical a “crisis”.

Indeed, one takeaway from both hearings is that clearinghouses, at least certain clearinghouses maybe too big to fail, which may be why a Federal Reserve member argued for the Fed giving them a backstop.

Their involvement in SWAPs along with all their other products, means taking on trillions in loan guarantees.

CFTC Commission Rostin Behnan is the chair of this committee and in his opening statement he made this announcement about a new sub-committee and its new chair.

“Today’s agenda begins with Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley and our newly appointed Chairman of the Interest Rate Benchmark Reform Subcommittee. Tom has more than forty years of experience as an industry leader and has served in multiple capacities at Morgan Stanley in New York, London, and Tokyo.” Behan stated in his opening remarks.“Over the years, he has held several key roles at the U.S. Treasury, the Federal Reserve Bank of New York, and currently serves as a member of the Alternative Reference Rates Committee (‘ARRC’) of the Board of Governors of the Federal Reserve System (‘Federal Reserve Board’), which will be particularly relevant to his role as the Subcommittee Chairman.

“The last meeting of the MRAC in July introduced benchmark reform as a key topic of interest not only to MRAC members, but also to anyone who has a car or small business loan, student loan, mortgage, or credit card. As highlighted by Chairman Giancarlo in remarks last week at the 2018 Financial Stability Conference, despite huge improvements in the governance process to produce LIBOR, the market for unsecured inter-bank term lending that underlies LIBOR has dried up, and the regulatory mandate compelling LIBOR submissions has an expiration date. Fortunately, there are coordinated initiatives underway specifically targeted at addressing the myriad of impending issues specifically related to the derivatives market. Chief among these initiatives is the ARRC, which is tasked with leading and directing the transition away from LIBOR to SOFR, the Secured Overnight Financing Rate.”

Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley

The SOFR, or secured overnight financing rate, was created by the ARRC, or Alternative Rate Reform Committee, which was created after the LIBOR trade fixing scandal.

The SOFR was supposed to compete and hopefully replace LIBOR as a market driven overnight rate.

The entire meeting was approximately six hours long and The Industry Spread will follow up on clearinghouse risk management in an upcoming article; for now, the meeting was another who’s who of industry heavyweights.

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